The debate whether speculation is driving food price volatility has come back to the forefront. Especially for low-income countries, such volatility in prices can increase food security risks, thus calling for a thorough investigation of the role of speculation on food markets.

Speculation is most frequently associated with investment operations in commodity futures markets, which are used by agricultural producers and buyers for hedging purposes. By agreeing on a future price of a commodity, the price risk of these market participants (“commercials”) can be transferred to investors (“financials”), who buy and sell futures contracts in anticipation of making a profit, adding liquidity to the market. This buying and selling of futures contracts with the objective of making a profit rather than reducing risks related to the physical exchange of the commodity can be referred to as “speculation”.

In order to determine whether speculation is indeed distorting food prices, it is important to consider that commodity futures markets can play their function as a price risk management tool only if they reflect the underlying value of the cash price, which is periodically guaranteed by the fact that futures contracts can be physically delivered. Although used for only a very limited share of the total positions held in futures exchanges, this possibility for a physical delivery allows market participants to take advantage of any price discrepancy between cash and futures price and ensures price convergence when contracts expire.

The literature usually identifies three ways in which speculation may destabilize markets: For one, speculative activities such as “trend following” (a market strategy based on buying when the price of commodity futures goes up and selling when the prices go down) may cause futures prices to regularly overshoot or undershoot the level of the underlying cash price. Although the literature is far from conclusive about the depth or frequency of this type of phenomenon, there is broad agreement that any effects would usually be short-lived.

In a second category, speculation is suspected to cause futures prices to periodically diverge from fundamental values in a more substantial way. In this context, activities of commodity index funds are viewed as a potential driver as they hold large long (i.e. buying) positions that can move the entire market. While the hypothesis of the existence of such a phenomenon raises legitimate concerns, the bulk of the evidence in the literature suggests that in practice these funds have little to no impact on commodity futures prices.

The last concern is about a potential manipulation during the delivery of a futures contract, usually coined as a “corner”. In these cases, a “manipulator” tries to gather a position to be delivered that is large enough to cause a divergence between cash and futures prices. Delivery manipulation is arguably the most concerning form in which speculation can impact markets as it breaks the very core function of commodity futures as a risk management tool. To avoid it, market regulators have implemented position limits, which set a maximum number of contracts that can be held for non-hedging purposes.

While opinions on the exact impact of speculation might differ, the activities of financial investors are usually regarded as indispensable to ensure the smooth functioning of futures markets. Allowing an adequate level of speculation for liquidity purposes without destabilizing markets is a delicate affair. By providing information on supply, demand and prices, commodity exchanges, market regulators and even initiatives such as AMIS all have a role to play to promote fair and orderly markets. Yet, even with fully transparent food markets, there might be instances when prices will be exceptionally volatile, and these require the urgent attention of policy makers in view of the detrimental impact that these situations might have on food security.